Tax erosion due to incorporation

In his fiscal update, the Chancellor expressed concern about the tax cost of incorporation (or as he put it, the “structural effect of rapidly rising incorporation and self-employment, which further erodes revenues”).

Incorporating a business can reduce tax revenues in two ways: by allowing the business owners opportunities to structure their remuneration in ways which reduce the total tax bill, and by offering the possibility of deferring some tax charge by retaining funds in the company until needed. Retained funds may ultimately be extracted as a capital gain at lower rates of tax in some cases.

The Chancellor indicated that the Government is looking at ways of addressing these perceived tax advantages.

Looking first at the total tax charge, the ongoing cuts in the headline corporation tax rate have increased the value of incorporation, although the recent increase in dividend tax rates claws back some of these benefits. With the Chancellor reiterating the intention to cut corporation tax to 17%, and the Prime Minister’s recent comments to the CBI being interpreted by some as signalling a future rate of 15%, incorporation may appear even more attractive.

One idea that has been considered by the Office of Tax Simplification is some form of “look-through” taxation for small companies. This would effectively treat some companies as sole traders or partnerships, so that the companies’ profits would be subject to income tax as if they were earned directly by the shareholders. Such a measure would undoubtedly level the tax playing field, but faces major obstacles due to the real legal differences between the business forms.

If such a major change cannot be made quickly (or at all) then we may see more changes in the rates of dividend income tax to deal with the declining rate of corporation tax. Of course, such changes would have a knock on impact on the taxation of portfolio dividend investments, potentially leading to further complex rules to protect investors.

On the deferral side, another proposal under consideration is a tax on undistributed profits of close companies. This would seek to offset the tax benefit of rolling up cash in a company by requiring the company to pay a tax charge where profits were not paid out within a certain period. It is expected that relief could be obtained where the company reinvested its profits in the business, or paid dividends at a later date. Again, the best case would be that such a measure increases complexity, and in practice other problems like double tax charges and disincentives to investment could well result.

Potential changes will be of importance to a range of small to medium-sized businesses that are incorporated or considering incorporation. This may be particularly relevant for property businesses reviewing their structure in the light of the buy-to-let interest deduction restrictions.

At present there is no concrete information on what form the Chancellor’s desire to address the issue will take. Further documents will be published on 5 December which may give an idea of the direction of travel, but in the meantime businesses should be aware of this uncertainty affecting the future tax framework.

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